“Many people may have been relieved to find that the chancellor in his Budget didn’t push up rates of income tax, as per one of the Government’s manifesto commitment from 2019. Instead, in what’s being called a ‘stealth tax’, the thresholds at which people start paying basic and higher rate income tax will be frozen at their 2021/22 tax year levels until April 2026. While that might not seem a big deal, according to the OBR it could mean over the next 5 years, one million people will find that because of even modest increases in their earnings, they will start paying higher rate income tax. In England** this will mean those whose earnings cross the threshold of £50,270 will pay 40% on earnings above this, twice the basic rate of 20%. For them, an increase in the basic rate from 20% to say 22% might no longer look so bad.
“The OBR make assumptions above average increases in earnings in future years of between 1% and 2%. If you’re earning over £46,442 and you received 2% pay increases for the next 4 years your earnings would be above £50,270 and you’d become a higher rate taxpayer.
“If you’re one of those estimated million people where a much needed pay rise means you face paying higher rate tax, one way to avoid this is to pay more into your pension. Your pension contributions get ‘tax relief’ at your ‘highest marginal rate’***. The way you actually get this varies**** but effectively, if you’re a higher rate taxpayer, it costs you £600 ‘net’ for every £1000 going into your pension. That’s a much better deal than basic rate taxpayers for whom it costs £800 net for every £1000.
“The way tax relief works has always made pensions particularly attractive for higher rate taxpayers. There were rumours ahead of the Budget that the chancellor was considering changing the rules, so everyone, whatever their income tax rate, would receive the same tax relief at 25%. This would have been good news for basic rate taxpayers but would have given higher rate taxpayers less of a boost. The chancellor didn’t introduce this change, but that’s not to say he might not return to it in future Budgets.
“So if you are already a higher rate taxpayer, or if you find that the freeze on thresholds means you become one in future years, it might be worth considering paying more into your pension, and getting higher rate tax relief while you still can. There can be additional benefits in doing so for those in receipt of child benefit.”
* https://obr.uk/overview-of-the-march-2021-economic-and-fiscal-outlook/
**The bands and rates of income tax are different in Scotland.
***Under the ‘highest marginal rate’ approach, individuals receive higher rate tax relief on contributions up to the amount that takes their earnings after pension contributions down to the higher rate threshold, and basic rate relief on the balance. So if someone earns £55,000 and pays £10,000 into their pension, they get higher rate relief on the £4,730 above £50.270 and basic rate relief on the balance.
****Under ‘net pay’, your employer deducts your pension contribution from your earnings before working out how much income tax you’re to pay. If you are earning £53,000, you’ll pay 40% tax on the extra over £50,270. But if you pay a pension contribution of £3000, your earnings for income tax purposes drop to £50,000 meaning you’ve no longer crossed over into being a higher rate taxpayer. Under the alternative ‘relief at source’, you pay contributions to a pension provider out of your net pay, they reclaim 20% tax relief from the tax authorities and you need to reclaim the additional 20% if you’re a higher rate taxpayer.
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